Question

Suppose you are advising a bank on the management of its balance sheet. In light of the financial crisis of 2007-2009, what arguments might you make to convince the bank to hold additional capital? During the financial crisis of 2007-2009, many banks failed and many more would have in the absence of government support. Holding additional capital will help avoid failure in the future by

Answer 1

Holding additional capital will help avoid failure in the future by reducing solvency risk. During the 2007-2009 crisis, the market value of many assets held by banks was downgraded to garbage and became practically worthless. At the point the government had to intervene (with TARP) to save banks from collapsing.

Instead of cash, banks had huge reserves of financial assets that were worthless, which meant that they had very little to pay their clients when they would try get their money out. The only way to reduce the solvency risk (bank not being able to meet cash obligations) is to hold more cash and increase capital.